Spotting Red Flags in A/R Financing
By Mark Mishler
MBA, CPA, CMA
Recent private credit lending failures, supposedly secured by borrowers’ accounts receivable, have raised red flags about non-bank private credit and potential collateral fraud. Jefferies Financial Group and UBS disclosed losses from now-bankrupt auto-parts supplier First Brands Group. JP Morgan and Fifth Third Bank disclosed losses from bankrupt TriColor Holdings, a used-car retailer and lender. BlackRock suffered losses with Broadband Telecom and Bridgevoice.
Even though the loans were less-traditional private-credit asset-based trade and supply-chain financing structures, the loans were collateralized and the lenders incurring these losses were not obscure small speculative lenders. Instead, they were large, sophisticated lenders with decades of deep experience in credit structuring and sophisticated collateral verification processes, as well as highly advanced lending systems, audit mechanisms, and internal control frameworks.
Ordinarily with factoring or financing receivables, credit risk exposure exists not with the borrower, such as First Brands. Instead, credit risk would be with First Brands’ customers, such as Walmart (AA rated) and AutoZone (BBB rated), who have significantly lower credit risk than First Brands. Of course, this relies upon the receivables actually existing.
According to published reports, the culprit at First Brands appears to be double-pledging of accounts receivable across multiple credit lines. The lenders subsequently discovered that the same accounts receivable assets were promised to multiple creditors.
In addition to double-pledging, the culprit at TriColor and Broadband appears to be fictitious car loans and falsified accounts receivable, respectively. The lenders did perform their receivable collateral verification of existence and amount by directly contacting the borrower/customer. However, they failed to identify that the return email replies came from fake addresses: A low-level lending employee first noticed inconsistencies in the customer return email addresses.
Not yet explained is how double-pledging could exist with standard Universal Commercial Code (UCC) filings. The lenders would have filed a UCC-1, which is a legal document creating a public record of the lender establishing a security interest (collateral) in a debtor's designated asset. Often referred to as a financing statement, it protects the lender by establishing the lender’s priority to seize and sell the collateral if the debtor defaults on the loan. It establishes the lender's legal claim and makes other potential lenders aware of the existing lien and collateral priority status.
How does factoring work -
Common forms of receivables financing include invoice factoring, invoice discounting, accounts receivable loans, and asset-based lending. Generally, this is financing of last resort for companies with low liquidity and lower credit rating that can’t qualify for standard bank term and revolver loans.
The borrower may sell its invoices or receivables to the lender, which is more transparent in the borrowers’ financial statements because the borrower derecognizes its receivables.
As an alternative, the borrower may pledge the receivables, which involves using receivables as borrowing collateral through a servicing agreement. This off-balance sheet financing is not transparently reflected in borrowers’ financial statements, and instead is more opaque financing that is primarily only reflected in borrowers’ financial statement footnotes.
Important to structuring receivables financing is establishing which entity in the financing chain directly receives the customer’s cash payment settling its accounts receivable. Several approaches exist for cash collection used in receivables financing or factoring, with each having different lender risk.
• Lenders directly collect customer payments into the lenders’ account.
This is least favorable to borrowers because it results in borrowers relinquishing control of their cash. This approach is least risky to lenders and standard for borrowers with low credit ratings, such as First Brands, which had a single-B rating (before bankruptcy). The transparency of this approach means it would be odd if double-pledging receivables could exist with First Brands, TriColor, and Broadband.
• Borrowers collect customer payments into their separately-segregated collection account.
This is more risky to lenders. Lenders, however, have continuous control or “dominion” over the borrowers’ “lockbox” account. Or, lenders have a “springing” mechanism allowing lenders to step in and take control if the borrower breaches certain conditions, such as a drop in liquidity. This approach is only available to more creditworthy borrowers with higher credit ratings, which would not include First Brands, TriColor, and Broadband.
Accounts receivable financing is a riskier financing structure. Accordingly, CFOs of lenders providing accounts receivable financing need to take additional precautions in verifying asset collateral existence and validating amounts. As a part of doing this, CFOs need to make sure they periodically test their collateral verification processes, lending systems, audit mechanisms, and internal control frameworks.
Even though the loans were less-traditional private-credit asset-based trade and supply-chain financing structures, the loans were collateralized and the lenders incurring these losses were not obscure small speculative lenders. Instead, they were large, sophisticated lenders with decades of deep experience in credit structuring and sophisticated collateral verification processes, as well as highly advanced lending systems, audit mechanisms, and internal control frameworks.
Ordinarily with factoring or financing receivables, credit risk exposure exists not with the borrower, such as First Brands. Instead, credit risk would be with First Brands’ customers, such as Walmart (AA rated) and AutoZone (BBB rated), who have significantly lower credit risk than First Brands. Of course, this relies upon the receivables actually existing.
According to published reports, the culprit at First Brands appears to be double-pledging of accounts receivable across multiple credit lines. The lenders subsequently discovered that the same accounts receivable assets were promised to multiple creditors.
In addition to double-pledging, the culprit at TriColor and Broadband appears to be fictitious car loans and falsified accounts receivable, respectively. The lenders did perform their receivable collateral verification of existence and amount by directly contacting the borrower/customer. However, they failed to identify that the return email replies came from fake addresses: A low-level lending employee first noticed inconsistencies in the customer return email addresses.
Not yet explained is how double-pledging could exist with standard Universal Commercial Code (UCC) filings. The lenders would have filed a UCC-1, which is a legal document creating a public record of the lender establishing a security interest (collateral) in a debtor's designated asset. Often referred to as a financing statement, it protects the lender by establishing the lender’s priority to seize and sell the collateral if the debtor defaults on the loan. It establishes the lender's legal claim and makes other potential lenders aware of the existing lien and collateral priority status.
How does factoring work -
Common forms of receivables financing include invoice factoring, invoice discounting, accounts receivable loans, and asset-based lending. Generally, this is financing of last resort for companies with low liquidity and lower credit rating that can’t qualify for standard bank term and revolver loans.
The borrower may sell its invoices or receivables to the lender, which is more transparent in the borrowers’ financial statements because the borrower derecognizes its receivables.
As an alternative, the borrower may pledge the receivables, which involves using receivables as borrowing collateral through a servicing agreement. This off-balance sheet financing is not transparently reflected in borrowers’ financial statements, and instead is more opaque financing that is primarily only reflected in borrowers’ financial statement footnotes.
Important to structuring receivables financing is establishing which entity in the financing chain directly receives the customer’s cash payment settling its accounts receivable. Several approaches exist for cash collection used in receivables financing or factoring, with each having different lender risk.
• Lenders directly collect customer payments into the lenders’ account.
This is least favorable to borrowers because it results in borrowers relinquishing control of their cash. This approach is least risky to lenders and standard for borrowers with low credit ratings, such as First Brands, which had a single-B rating (before bankruptcy). The transparency of this approach means it would be odd if double-pledging receivables could exist with First Brands, TriColor, and Broadband.
• Borrowers collect customer payments into their separately-segregated collection account.
This is more risky to lenders. Lenders, however, have continuous control or “dominion” over the borrowers’ “lockbox” account. Or, lenders have a “springing” mechanism allowing lenders to step in and take control if the borrower breaches certain conditions, such as a drop in liquidity. This approach is only available to more creditworthy borrowers with higher credit ratings, which would not include First Brands, TriColor, and Broadband.
Accounts receivable financing is a riskier financing structure. Accordingly, CFOs of lenders providing accounts receivable financing need to take additional precautions in verifying asset collateral existence and validating amounts. As a part of doing this, CFOs need to make sure they periodically test their collateral verification processes, lending systems, audit mechanisms, and internal control frameworks.
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